Latvia: Going beyond the fiscal austerity debate

‘What is it about Latvia’, laments Simon Wren-Lewis, that leads commentators to suspend their ‘critical faculties’ when discussing the current economic circumstances of this Baltic state?[2]Latvia is at the epicentre of the debate on ‘expansionary’ fiscal austerity. Can one really claim that the best way to handle a major recession-inducing external shock for a small, open economy resolutely committed to a fixed exchange rate regime is to engage in a bold and decisive fiscal consolidation? It is a confident ‘yes’ from senior EU officials, the IMF Managing Director as well as some time long-time backers of the Baltic states, such as Anders Aslund of the Petersen International Institute.[3]

Critics of this approach – Wren-Lewis, Krugman and Weisbrot, to name a few – are dismayed by such proclamations.[4] They argue that external devaluation and a gradual approach to fiscal consolidation would have entailed much lower social and economic costs in dealing with the extreme boom-bust cycle of 2007-2010. After all, after growing at double digit rates in 2005-2007, Latvia attained the unenviable record of suffering the steepest decline in output in the world in recent years. GDP contracted by more than 20% between 2008 and 2010. Unemployment increased from 6.2% in 2007 to a peak of 19% in 2010. The projected unemployment rate for 2012 stands at 15.5%, representing a sharp contrast to the EU average of 11%.[5]

Latvia was the first country in Europe to join an EU and IMF supported programme in December 2008 to cope with the fall-out of the global economic and financial crisis. With generous financial assistance amounting to well over 30% of GDP, the Latvian authorities instituted a fiscal austerity programme of approximately 15% of GDP between 2008 and 2011. Policy-makers made a resolute commitment to defend the exchange rate peg between the Lat and the Euro given the aim to enter the Euro zone in 2014. There were quite drastic across-the –board cuts in public expenditure, while both nominal and real wages fell, most notably in the public sector. Latvian authorities and their international patrons claim that the strategy of fiscal consolidation-cum- ‘internal devaluation’ paid off. Latvia successfully graduated from the IMF supported programme in December 2011. Latvia became the fastest growing economy in the EU in 2011 registering a growth rate of 5.5%. The current account and the budget deficit now appear to be in sustainable balance. Latvia managed to return to international bond markets as borrowing costs came down appreciably.[6]

The IMF and EU officials mingled with 400 participants in Riga on June 5, 2012 to ‘celebrate the remarkable achievements of Latvia and other Baltic states over the past few years’.[7]Of course, one must not overlook the external imperatives behind such a celebration. As a senior EU official, perhaps unwittingly, observed: ‘We desperately need good stories and not only the difficult ones that dominate the news right now’.[8]

Beyond the need to look for ‘good stories’, can one suggest with any degree of confidence what is the medium and long-term outlook for the Latvian economy and its peoples? Harvard economist Dani Rodrik adopts the role of a neutral referee and observes: ‘It is too early to judge the Latvian experience a success. But it is also too early to say Latvia is a failure. Growth may continue, in which case the country will look better and better’.[9]The key issue is not whether ‘growth may continue’, but whether it will be sustainable, inclusive and rapid enough to make a major difference to the lives of ordinary Latvians.

We draw on medium-term projections (to 2017) by the IMF on growth and unemployment to form a sense of where Latvia seems to be heading.[10] We reinforce this assessment by using multiple sources to form a view of Latvia’s medium- term and long-term outlook. It appears that, while Latvia has, against all odds, managed to defend its fixed exchange rate system in a bid to join the Euro zone by 2014, its policy-makers now paradoxically face an uphill task to fulfil the goals and targets of the Euro 2020 strategy of social inclusion. It might also be facing a ‘demographic disaster’ that is being unwittingly hastened by current policies.[11] Hence, the success of its fiscal consolidation strategy might turn out to be a Pyrrhic victory.

If one makes the plausible, but quite conservative, assumption that Latvia’s long-run growth potential is around 5%, then it appears that the growth recovery is not adequate enough.[12] Between 2012 and 2017, the IMF projects that the economy is expected to grow at an average rate of 3.2%. This too is contingent on what happens to the evolving sovereign debt crisis in the Euro zone. It is this moderate - and uncertain - pace of recovery that perhaps explains why it will take another three years (2015) before the Latvian economy reaches the 2006-2007 pre-crisis real GDP level.

The projected and relatively slow pace of growth also offers a clue as to why double digit unemployment rate is expected to prevail in Latvia until 2017. Even then, at a projected rate of 9.4% in 2017, the unemployment rate will be well above any reasonable estimate of the NAIRU.

One should also take account of the ‘hysteresis’ effects of persistently high unemployment. A good gauge is the share of the long-term unemployed (more than six months duration) in total unemployment. This indicator rose from less than 20% in 2007 to well over 50% by 2011.[13] The longer the unemployed remain detached from the labour market, the longer their skills atrophy and the higher the risk of low employability. Hence, many thousands of Latvians face the enormous challenge of being re-integrated into the world of work.

Then there is the issue of high youth unemployment and the correspondingly low rate of employment. In the third quarter of 2010, for example, the youth unemployment rate stood at 32.4%, while the employment rate was merely 28.9%.[14] As is well known, when young people become unemployed during recessions, they risk ‘scarring’ effects because of reduced prospects of employment and earnings that can last for decades.[15]

The grim legacy of the deep recession between 2008 and 2010 is that Latvia will struggle to meet the goals and targets of the Europe 2020 strategy that emphasises an agenda of social inclusion. Among these targets, two of them are noteworthy: substantially reducing the number (by 121,000) at risk of poverty or social exclusion by 2020 and providing employment to 73% of the work-force.[16] The 2008-2010 recession has turned out to be a setback when seen from the perspective of the Europe 2020 strategy. Given that the employment rate fell from 75.8% in 2008 to 60.7% in 2010, meeting the EU jobs and poverty reduction targets by 2020 are likely to be a significant challenge.[17]

It must be remembered that Latvia is one of the poorest countries in the EU with an average income that is half the level of EU 27.It is also one of the most unequal countries in the EU. The severe recession of 2008 to 2010 has exacerbated these structural traits. Simulation studies undertaken by the World Bank and others during the depth of the recession suggested that poverty and inequality would deepen, with the former projected to rise from 14.4% at the end of 2008 to 20.2% of the population by the end of 2009. The Gini coefficient (a measure of inequality) which stood at 39.3% at the end of 2008 was projected to rise to 41.3%.[18]

The grim scenarios depicted by the simulation studies have been exceeded since then by more recent survey-based data. For example, based on the EU Survey of Income and Living Conditions, the proportion of households having ‘great difficulty in making ends meet’ jumped from 13% in 2008 to 24% in 2010/2011. Those ‘at-risk-of- poverty’ rose from 33.8% to 40.1% over the same period.[19]

These increases in both material deprivation and economic insecurity are occurring in a country that is notable for its lack of a comprehensive social security system. Latvia spends far below the EU average on passive and active labour market measures which means rather low effective coverage of the poor and the vulnerable. Coverage rates have worsened in recent years. For example, those not covered by unemployment benefits rose from 48% in 2008 to 76% in 2011.[20] The 2008-2010 recession triggered some emergency social safety net measures, such as a public works programme, but the government appears reluctant to perceive them as part of a long term and comprehensive social protection system.[21]

The EU also conducts public opinion surveys (Eurobarometers) among its member states to provide subjective assessments of EU citizens about current and prospective living conditions in their countries. A notable feature is the extent to which respondents perceive the economic situation to be ‘bad’ and whether they expect the worst is over. For Latvia, the results appear grim. In 2009, 97% of those surveyed classified the situation as ‘bad’. By 2011, when the GDP growth rate was the highest in the EU, 91% still perceived the economic situation to be ‘bad’, while 58% felt the worst was yet to come![22]

One of the most telling aspects of the Latvian economy is that it is afflicted by adverse demographic trends. Mihail Hazans, Latvia’s leading (and award-winning) labour economist has issued the apocalyptic warning that the country faces a ‘demographic disaster’. The Latvian population has been shrinking steadily between 2000 and 2011. In 2000, the Latvian population was 2.37 million. By 2011, it shrunk to 2.23 million. By 2017, it is expected to decline to 2.19 million. This reflects a combination of high emigration, falling birth rates and rising death rates. A back-of- the envelope forecast suggests that the size of the economically active population will shrink from more than one million to 900 thousand between now and 2020.[23]

Latvians – like other neighbouring Baltic states - have a high propensity to emigrate. The 2009 Euro barometer noted that 45% of those surveyed wanted their children to migrate to another EU country (one of the favoured destinations being UK) for a better future. Hazans claims that 80,000 Latvians – equal to 3.7% of the pre-crisis population – left Latvia between 2009 and 2011 for better economic opportunities abroad. In all, he claims that ‘at least’ 230,000 Latvians have emigrated between 2000 and now, with most unlikely to return. More importantly, the emigrants are typically young and skilled with the consequence that Latvian society is experiencing a ‘brain drain’ and ageing at a faster rate than the rest of the EU.[24]

The current Latvian Prime Minister, and one of the architects of the fiscal austerity programme, correctly notes that ‘the main reason behind emigration is…lack of jobs and lack of well paid jobs. That’s what we need to concentrate on if we need to deal fundamentally with emigration’.[25] As the debate on the pros and cons of the fiscal austerity programme in Latvia continues in the blogosphere and in international policy-making circles, many thousands of young and skilled Latvians are not prepared to wait for an answer. They are voting with their feet. As they seek a better future abroad, they are ironically casting a shadow on the economic future of Latvia.

[1] Iyanatul Islam, ILO, Geneva and Griffith University, Australia; Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or any of its agencies/funds/programs

[3] Lagarde, Christine (2012) ‘Latvia and the Baltics – a Story of Recovery’, IMF, Riga, June 5. Available at http://www.imf.org/external/np/speeches/2012/060512.htm;Aslund, A and Dombrovskis, V (2011) How Latvia Came Through the Financial Crisis, WashingtonDC : Peterson International Institute for International Economics

[12] The Ministry of Welfare of the Republic of Latvia notes that the medium-term target for GDP growth is 4 to 5%. See The Ministry of Welfare of the Republic of Latvia (2011) ‘Latvian Labour Market, 2010-2011’, p.20.

[13] IMF (op.cit) p.6. This is an improvement from the end of 2010 when the share was 61%. See The Ministry of Welfare of the Republic of Latvia (op.cit) p.6.